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Is Nathan's Famous the Next Great Restaurant Stock?

Is Nathan's Famous more similar to Krispy Kreme or Chipotle?

A few years back a reality show with Bobby Flay sought to find the "next" Chipotle(NYSE:CMG)While the potential investors really just wanted the next great restaurant, they were surprised at how many contestants simply copied Chipotle's model (with Mexican food, Indian food, etc.). That show turned out to be very prophetic. Today a glut of fast casual IPO's have crowded the market attempting the same; yet they don't understand what really makes a restaurant great. It's not the business model. Hot dog cult favorite Nathan's Famous (NASDAQ:NATH) has long seemed to be more like Krispy Kreme Doughnuts(NYSE:KKD), than a great restaurant, but after a strong fourth quarter, Nathan's may be moving closer to the latter.

Here's a recap of Nathan's quarter.

Image courtesy of Nathan's Famous

Nathan's at a glanceNathan's Famous is, in short, the Cadillac of hot dogs. Founded by immigrant Nathan Handwerker in 1916 with a single stand in Coney Island, the hot dog icon has expanded to 303 units with its flagship stores being located primarily in the New York City metro area. This figure does not even include its co-branded locations, of which Nathan's does not receive royalties. It sold 435 million hot dogs, through its stores and retail partners, in the last year alone.

Yet with all its success, the stock is a scantly traded small cap with a market capitalization of just above $230 million. After a great quarter, now may be the time to get in on the growth.

For the fourth quarter Nathan's revenue rose 15.7%. Earnings slipped slightly for the quarter to come in at $0.27/share, but net income was up 11.5% for the full year. For the full year, sales from company-owned stores suffered due to an eight-week closure that resulted from Super Storm Sandy, but sales from Nathan's Branded Product Program were up 20%. Potentially, if retail store sales stay strong, restaurant sales could lead to a better 2014.

The IconBefore I wrote this, I worried that Nathan's, like Krispy Kreme, may be too unhealthy a product for large scale growth. Healthier alternatives, Chipotle including, seem to be doing better these days.

But Nathan's offers something Chipotle does not, a truly iconic brand. Chipotle started with a strong brand that has become stronger, but it's not an icon. Tourists who go to New York stop at Nathan's as a landmark. In some ways it's similar to Lou Malnati's in Chicago or Geno's Steaks in Philladelphia. For that reason alone, Nathan's offers something unique to investors.

Nathan's last two years were hurt by temporary closings at its landmark locations. If the company can grow its franchise base, earnings will become more consistent. Very few restaurant stocks have iconic brands, and I believe Nathan's brand can help overshadow its risks.

Risks associated with Nathan's Krispy Kreme has maddened investor's looking for store growth over the years because, as its most recent quarter showed, it performs better in supermarkets than in stores. In some ways, Nathan's business model provides a similar risk.

The main difference is Nathan's largest growth driver, at this point, is its branded products program. This program allows others retail outlets (big box stores, sporting arena's, etc.) to actually cook and serve Nathan's products. This program has been the main driver of growth since 1998, and now management wants to leverage it, along with Nathan's licensing business, to grow its franchise base. There's three risks associated with this plan.

1. Nathan's branded products group allows both sports teams and K-Mart's alike to be associated with its brand. Management is relying on this brand familiarity to drive franchise growth, but if quality suffers, it could do the opposite.

2. Nathan's is also leveraging its presence in supermarkets through its licensing program. Investors shouldn't count on this unit to deliver growth, because Nathan's is already in 33,000 locations across forty-five states. This means the franchise unit and branded products group must drive most of the growth.

3. Nathan's only has three company owned stores, the rest of its units are franchises. It is relying on franchise growth, but the franchises have a smaller menu, and the company (obviously) has less control over their day-to-day operation. There is a risk that these units will not be as popular as the landmark locations and, therefore, unit growth may have a ceiling.

Nathan's management believes that the "familiarity" of its branded products group will lead to a new level of restaurant growth. The branded products group grew faster last quarter than it did in 2013 (12.5%). I tend to agree with them but, like any growth stock, there are significant risks.

What makes a restaurant great?I started this article by asking if Nathan's could be the next great restaurant stock. Nathan's business model is not perfect and it sells junk food, but it does have one trait that all great restaurants share. Customers go out of their way to go to Nathan's stores.

If you're in Coney Island, it's a destination. I'm banking on the idea that this iconic brand has legs outside of its New York base. When you consider that the stock has a reasonable valuation and some pretty impressive sales, it may just be the next great restaurant stock.

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